How to Build a Diversified Portfolio in Real Estate
Why Diversify?
When someone approaches an investment opportunity, the first question they typically ask is “What kind of return am I going to get?” It’s a fair question, but by itself, it doesn’t really paint a full picture.
Whatever return is projected is a great consideration, but we also have to ask whether or not it’s a safe, reliable, and consistent return. If it turns out that you’re getting predictable returns every quarter, then it stands to reason that you’re in for smooth sailing. On the other hand, if the return is fluctuating up and down and shifting in accordance with what’s happening in the market, you need to prepare yourself and your portfolio for the unpredictable nature of volatility.
So the main question is why diversify your portfolio?
The answer comes down to whether you prefer smooth sailing with a predictable, steady ride or the roller-coaster ride that comes with volatility. Younger investors tend to like the ups and downs and twists and turns of the latter, but, as we grow and our portfolios get some mileage on them, we tend to prefer more predictable outcomes, if nothing else, to prepare us for retirement.
This means that investment objectives and decisions can change over time… if you’re young, you might roll the dice and take a lot of risks with your money, investing in highly speculative deals which, when they play out successfully, have nice payoffs. Even when they don’t, you still have time to correct. That’s the beauty of youth.
On the other hand, if you’re at a point in your life where you’re looking to live on the income derived from your portfolio, the smoother sailing that comes with more stable investments is probably far more appealing.
Volatility doesn’t necessarily guarantee a higher level of return. All it means is that there’s a potential for a higher level of return, but it doesn’t mean it will help. That’s one of the reasons why investors diversify.
The Four Main Building Blocks in a Diversified Real Estate Portfolio
So how do you go about building a diversified portfolio? In real estate there are four main building blocks: funds, syndication, partnerships, and direct ownership. Let’s start by discussing funds, the foundation of your portfolio, and then we’ll look at the other three.
Funds
Funds are appealing because they’re more diversified, comprised of many different projects, and usually have better liquidity then syndication. Another upside in the case of funds is that, as the investor, you’re completely passive and disengaged–in other words, you’re not involved.
What types of funds am I talking about here? Most people think of Wall Street funds which is one way to look at it. They’re called real estate investment trusts which are certainly stable, predictable vehicles.
However, these types of funds only invest in stable assets with predictable cash flow because the objective is to generate a predictable yield with a little bit of growth as the portfolio value increases. These are mostly income focused, stable funds.
On the other side, private funds are typically offered through a private placement memorandum, and they could be very broad and diversified or very narrow and focused.
It’s crucial that you read the prospectus to understand what’s being invested in. For example, the Tempo Opportunity Fund LLC is a broad diversified fund with investments in a number of stable investments with good income and some value-add projects that generate “forced appreciation” or growth. It’s an income and growth fund which is part of its strategy.
The fund’s growth comes from value-add projects which we invest in. We strive to take advantage of both: strong income and good growth associated with this. Value-add projects increase in value when are complete, meaning they’re worth more money due to improved cash flow and the assets themselves.
Again, the right type of funds could significantly increase the value of your portfolio.
Syndications
A syndication is typically a single asset with many investors. It’s a project such as a self-storage conversion from an old big box store, or it could be an older multi-family asset due to be renovated into a better facility… going from a C quality facility to a B minus or straight into a B with rents going up, etc.
In this case, the asset is improving and getting repositioned. These types of projects could be very worthwhile investments.
Syndications do have drawbacks in that they have no liquidity, at least not until they get through the end of the value-add life cycle and then sell or refinance.
But, truth be told, it all depends on the project. It comes down to the quality of project or fund that determines if you can make more money in a syndication than a fund, or the other way around.
Remember, with syndications, you’re offered access into a single project, but you have to be careful because there isn’t a diversified portfolio, just a single investment. They’re very capable of generating really solid returns with a good project and a good sponsor at the helm.
Partnerships
Whereas funds and syndications are passive investments that require little to no involvement on your part, with partnerships and direct ownership you are absolutely involved with the property. You could play the role of money partner, credit partner, the experienced partner, or the mentor-ship partner. Here, you’re participating with other people who you know, like, and trust with whom you’ve decided to go into business on a particular property.
An example would be that you’ve decided to buy an office building which the group plans to renovate and rent out to a new group of tenants (or upgrade existing tenants).
So, it’s a partnership. And like we mentioned earlier, it’s part of a diversified portfolio, and it does require some active involvement in contrast to funds and syndications.
Direct Ownership
Direct ownership is similar to a partnership in its nature but in this case, you’re responsible for everything. Let’s say you’ve just bought a quadruplex in which you have four tenants and you’re self-managing the asset. You could hire a third-party manager in this instance, but you have to determine if that’s economically feasible.
If you hire a part-time maintenance worker to help with problems that arise that’s probably economical. But if you can’t find someone who fits this bill and need to hire a professional management company, they’ll end up taking part of your revenue.
Or you own a few single family residential properties, typically known as turn-key properties, which might end up in a market far away from where you live. In this case you aren’t able to directly manage and need to hire a third-party property manager. They’ll typically take 10% of your rent roll to manage the property.
One of the drawbacks to direct ownership is the return on time which may not be great. It all depends on the type of asset. If you bought a direct ownership, and it’s a big building, that’s great. If, on the other hand, you bought a small asset that requires some level of interaction with the renters or tenants, your return on time will be impacted.
So, depending on your situation, direct ownership could certainly be part of your diversified strategy along with funds, syndications, and partnerships. If you’re investing tens of millions of dollars and buying these direct assets which are multi-million dollar buildings, you could hire third party management, but it you’re investing in smaller assets then just be aware of your return on time.
What Makes a Diversified Portfolio
From my experience, 30-plus investments qualifies as a diversified portfolio. Though that seems like a large number, funds count for many different types of investments in that they’re diversified by definition. You should also strive to diversify across many different elements and dimensions.
Another rule of thumb is that no single investment type should make up greater than 10% of the portfolio.
Portfolio Size & Diversification
1. Make It Easy to Manage
It’s key that you build a portfolio that’s easy to manage. Be sure that you pick your investments carefully; if not, you’ll have to babysit them. Despite the theme we’ve been pushing throughout this article, it’s possible to over-diversify. Remember the 30 + rule… that seems to be a good, solid number that allows for an ample amount of diversification. Much more than that and you’re looking at a portfolio that has the potential to be unwieldy.
Remember how we emphasized the importance of Return on Time Invested? Your total return equals your Return on Investment (ROI) + Return on Time (ROT). Be sure that you’re fully aware of the extent to which this equation plays out in your portfolio.
2. Diversify with Investment Quadrants in Mind
I’m a firm believer in utilizing the structure of the investment quadrants as a guiding principle for investing in general. When it comes to diversification of your portfolio, the quadrants, clearly, are applicable as well. You have to determine your level of comfort, and the quadrants are an effective tool for making that determination.
Quadrant One
This is an investment grade quadrant that’s cashflow focused characterized by good downside protection with a low-to-moderate degree of risk involved. There’s a healthy degree of initial cash flow generated from first lien performing notes and moderately leveraged equity deals. If you’re mindset is low-to-moderate risk then this is the best fit.
Quadrant Two
This is also an investment grade quadrant, but, in contrast to quadrant one, it’s growth-focused. Similarly to quadrant one, it has good downside protection but has no (to very limited) cash-flow. That’s due to the fact that investment vehicles are first lien non-performing notes and light-to-moderate value-add projects.
Quadrant Three
This quadrant is speculative grade which equates to higher risk and limited downside protection. However, there’s strong initial cash flow that stems from highly-leveraged equity deals and second lien performing notes.
Quadrant Four
Finally, like the previous quadrant, quadrant four is speculative grade characterized by high risk and limited downside protection due to the nature of the assets: development, redevelopment, and land speculation. There is no (to limited) initial cash-flow in this category.
Wrap Up
As of mid-June, the Tempo Opportunity Fund has a variety of equity investments including multi-family units (5), self-storage (4), shopping centers (6), an office building, residential building, corporate debt, a fund, distressed debt, as well as outstanding loans (64). Our portfolio is spread across the four quadrants in an equitable manner and contains nine different categories of assets.
As mentioned above, it’s an income and growth fund which is part of our strategy. The fund’s growth comes from value-add projects in which we invest. Tempo strives to take advantage of both: strong income and good growth.
If you’re interested in learning more about how you can invest in the Tempo Opportunity Fund LLC, please visit http://secure.tempofunding.com or contact me, Mike Zlotnik, at mike@tempofunding.com or by phone (917-806-5029). I’ll be happy to forward you the PPM, term sheets, and subscription paperwork or answer any questions you might have.
“Please don’t miss the latest Episodes on Big Mike Fund Podcast:
042: How to Raise Money from Mom and Pop Investors episode with Jay Connor
041: Real Estate Syndication Explained: How to Get Started
Thanks for reading,
Mike Zlotnik
CEO, TF Management Group LLC
This newsletter and its contents are not an attempt to sell securities, nor to sell anything at all, nor provide legal, nor tax accounting, nor any other advice. The presenter is a private lending and real estate fund management business, and the information represented herein are purely for educational purposes and represents the opinions of the presented. Prior to making any investment or legal decision you should seek professional opinions from a licensed attorney, and a financial advisor.
TF Management Group LLC (TFMG) is an investment fund management company that specializes in both short-term debt financing for real estate “fix and flip” projects, and long-term “value-add” equity deals.
